On The German Reunification

The Captain asked, why the German government relied on taxes to finance the improvement of East German economy, instead of letting private investments do the job. Here is my answer:

Well, no, private investment wouldn’t have come in. The unification already ruined the Eastern German economy because of several political decisions.

Firstly, because it was decided that Eastern Germany had to reach at least 70% of the averag wage level of Western Germany in order to prevent massive migration to the Western states. During 1990 and 1991, before this measure was implemented, an estimated 1 to 2 milion East Germans moved to West Germany. East Germany’s population in 1989 was 17 million. So, unions and employers’ organizations were ordered to accepted only wages above the aforementioned level, creating massive unemployment overnight. But, not suprisingly, mass migration stopped thereafter.

Secondly, the laws of Western Germany became also the laws of Eastern states, thereby adopting the same inflexible labor market (labor protection, high unemployment benefits) in those states. High unemployment benefits were necessary to hold the unemployment in Eastern Germany, that is, to prevent them from coming to West Germany in order to look for jobs.

Third, all major infrastructure investment like roads, electricity, railroads, water supply, and telecommunication, were, and still mostly are, government investments, i.e. those things are state-owned and private competition isn’t allowed.

Last, but not least, when they introduced the Western Mark, they set the exchange rate at 1, which was a symbolic act, because the real traded rate was at 6 or 10 Eastern Mark for Western Mark. This led to a massive overvaluation of East German goods and services, effectively rendering them uncompetitive.

Did you know that Eastern Germany received a third of its GDP as subsidies from Western Germany in the first years after reunification? Interestly, somehow politicians have lost the count on how much money was transferred until now. Estimates range between €250 billion to €1.5 trillion. The latter number would equal Germany’s total public debt as of 2009.

3 comments on “On The German Reunification”

I have an interesting question that you, as a German, may be able to ask. Are people in Germany aware that due to the Euro Germany and the other trade surplus countries are currently transferring wealth to the deficit nations like Greece, Italy etc ? I haven’t tried to calculate how much, but currency mechanisms would have all the old currencies fluctuate with the surplus ones going up, and the deficit ones going down – no longer so with the unified Euro-zone.

Is this something that is discussed by German politicians? Especially now since there is a mad government spending spree in certain Euro-countries (Greece budget deficit of 10% – and price inflation will kick in hard within a couple of years). My take has always been that if Germany and the other trade surplus countries realized how much wealth they were actually being forced to give away to support a currency that the other nations constanlty pressured downwards – they would force monstrous deficit/inflation rules on the deficit nations (unlike the current budget/inflation rules which no one seem to care about).

Just a thought – all common sense says that unless the deficit countries shape up then Germany is better off re-introducing the Mark, and killing the euro.

There are two different problems with the Euro. The first one is the lack of exchange rates between Euro members. Germany should do better under the Euro regime, if the Deutsche Mark would appreciate even stronger, for the growth in exports keeps the German economy running. The ones who are suffering from the Euro are certainly the countries with current account deficits, i.e. Spain. Without exchange rates between those countries, prices have to adjust, which benefits countries that have low inflation, e.g. due to a sluggish domestic economy (Germany). The tragic coincidence that Germany has a poor domestic, but a stellar export economy leads to the dilemma that Spanish prices rise faster than German prices, thereby increasing the inbalances. You can look here for some compiled data about the evolution of real exchange rates under the Euro.

That being said, no there is no discussion about this issue in Germany. When the Euro was introduced, Germans were frightened by the possibilty that countries like Italy or Spain could ruin the Euro. That proved to be untrue for the first 8 years. Generally, the German public and the politicians fundamentally lack any understanding of economics.

The second problem, which is also not publicly discussed, is the no-bailout clause in the Maastricht criteria. If fiscal deficit countries like Greece get bailed out some day and the markets expect that, interest rates on Greece debt will not rise as high as they should (in order to reflect the risk premium associated with holding Greece debt). In that case, indeed wealth is transferred, as fiscally irresponsible countries like Greece take a free ride on fiscally responsible countries like… Anyway, the no-bailout clause was invented so that the bad countries have to pay the full cost of their behaviour as soon as doubts over their sustainability emerge. The fact that Italian rates have risen signifcantly in the last year seem to prove that it works. However, it also seems improbable that the Euro zone will really let a country default, if it ever comes to that point. They don’t even let countries outside the Euro zone default! (Ukraine, Hungary, etc.)